Why the S in ESG?

For trustees, social investment offers an opportunity to align a charity’s investment strategy with its charitable goals. Bringing about social change, from alleviating poverty to tackling discrimination to preventing abuse, is often core to a charity’s purpose. Social impact investing allows a charity to super-charge its impact in key areas.

There are also strong arguments that social investing can improve investment returns and help manage risk. Why does it make such a difference? Perhaps the most important is that proper management of social factors gives companies their ‘licence to operate’. This is more than simply reputation — though that is a factor – but is about a company’s legitimacy with all its stakeholders. If it doesn’t manage its social responsibilities effectively, it loses its relationship with its employees, its customers and its shareholders.

A recent Harvard Law School report, written by Jonathan Neilan, Peter Reilly, and Glenn Fitzpatrick said social practices are likely to become increasingly important in a more complex and difficult economic environment: “Factors relating to ‘S’ are now among the most pressing issues for companies globally…Entire sectors of the economy, and not just the weakest players, are facing a stark and uncertain future. We believe now, more than ever, that a company’s reputation—its ‘licence to operate’—will be a function of how it engages and manages it stakeholders through this crisis; and how it communicates that responsibility—the ‘S’—to its stakeholders in a clear and transparent way.” (1.)

The authors also believe that strong performance on social metrics can be taken as a barometer for corporate culture: “Where companies have a strong and shared culture across the organisation, [social] practices tend to be strong. Where a culture is poor or considered “toxic”, [social practices] tends to follow the same pattern.” (1.)

Social practice can not only be a risk for companies but also an opportunity. Companies that manage their human capital successfully will be better at attracting, developing, and retaining employees. In turn, they are likely to be more resilient, remain competitive, and thrive. Companies that treat their employees poorly, beating them down on pay or compromising on working conditions won’t be able to attract skilled staff, hampering their growth over the long-term.

Just as it has become an increasing priority for society, these considerations have become an increasing priority for investors. The pandemic galvanised movements such as Black Lives Matter and brought a far greater focus on the well-being of staff. It has also shown the vulnerability inherent in weak supply chains and neglecting labour rights. Poor social performance becomes a greater risk for corporate performance and a threat to companies’ reputations, investors are giving it a higher weight.

The more investors take an interest, the greater the link to share price performance. There is already evidence that companies scoring well on social and governance metrics deliver higher performance. In the latest Federated Hermes report ‘ESG investing: how Covid-19 accelerated the social awakening’, it says: “Companies with good or improving corporate governance have tended to outperform companies with poor or worsening governance by 24bps per month on average – unchanged from our 2018 study. The social premium, however, has marginally increased from an average of 15bps per month in 2018 to 17bps in 2020.” (2.)

As investors, we need to make sure that companies are run in a way that is sustainable for the next generation. That means proper management of human capital, preserving a company’s ‘licence to operate’ and ensuring its long-term reputation with clients and other stakeholders.

Sources

1. https://corpgov.law.harvard.edu/2020/06/28/time-to-rethink-the-s-in-esg/
2. https://www.hermes-investment.com/ukw/wp-content/uploads/2020/12/fhi-esg-investing-commentary-q4-2020.pdf

Approval ref: 22083800